An Uphill Economic Battle for Japan

The world’s third-largest economy has entered a technical recession after contracting for two straight quarters, revised official data showed last month.

Analysts believe economic conditions probably worsened in the current quarter due to collapsing exports to China and the European Union, falling domestic auto sales and decelerating post-tsunami reconstruction spending.

But the negative news doesn’t end there.

Japan’s industrial production slumped last year, and deflation persists, according to Credit Suisse. Lumbered with the highest debt-to-GDP ratio in the world, Japanese officials have been forced to cut public spending.

Newly elected Prime Minister Shinzo Abe, whose Liberal Democratic Party was swept back to power in the Dec. 16 general elections, wants to grow the country’s debt by spending trillions of yen to revive the economy and lower the value of the currency to help exporters.

The seemingly never-ending negative data helps his case.

The Bank of Japan is also doing its bit. In December, the central bank boosted its asset-buying program by Y10 trillion.

But when the central bank announced a similar-sized boost in October, Credit Suisse analysts noted in a report that the Bank of Japan should be aggressively loosening monetary policy and ramping up its monetary easing program.

“We are disappointed that the sharp deterioration in recent economic data did not lead the Bank of Japan, at its October meeting, to extend its asset purchase program beyond the end of 2013 and only increased the target by Y11 trillion,” Credit Suisse said in the report.

Japanese policymakers are aware of the challenges, particularly the country’s enormous debt, which is more than twice the size of the economy. In November, the central bank voted to maintain near-zero short-term interest rates in a bid to lower the yen and boost Japan’s export-driven economy.

If they needed a reminder about the gravity of the situation, it came from the International Monetary Fund two months ago.

The IMF’s Japan Sustainability Report warned that the country’s debt “could quickly become unsustainable” if government bond yields rose suddenly. Questions about Japanese solvency would create dramatic market uncertainty, which would have dramatic implications for the global economy.

Should foreign investors lose confidence in Japan’s finances and start demanding higher bond yields, the country’s banking system could also be in trouble. Japanese sovereign debt accounts for 25 percent of total assets held by domestic banks. A rise in the interest rate could discount the value of these bonds and potentially lead to huge losses.

Such holdings “tie banks ever closer to the sovereign, potentially weakening financial stability should interest rates rise,” Jose Vinals, director of the IMF’s monetary and capital markets department, was quoted as saying in the Financial Times in October.

Last month, Bank of Japan Deputy Governor Kiyohiko Nishimura said the central bank would do what it takes, including extending its easing program to jump-start economic activity.

“The bank has been and will always be ready to take appropriate and decisive action when the economy strays too far from the baseline scenario of the outlook for economic activity and prices,” Nishimura said on Dec. 5 in a speech to business executives in the northern city of Niigata.

According to many Japan-watchers, the central government could find itself under considerably more political pressure to do so now that the Liberal Democratic Party is back in power.

Indeed, a recent analysis led by Credit Suisse’s Chief Japan Economist, Hiromichi Shirakawa, shows that loosening monetary policy may not, on its own, be enough to jumpstart the flailing economy.

A scenario of looser monetary policy resulted in GDP growth of less than 1 percent over the next two years, the analysis showed. But a fiscal stimulus of Y5 trillion a year could boost GDP by an estimated 1.6 percent. The two measures combined could bump up growth by 2 percent, Shirakawa’s analysis shows.

“This is because the positive ramifications of a weaker yen for exporters under a monetary easing scenario would be at least partially offset by the negative impact on domestic demand of a sharp rise in long-term interest rates,” Shirakawa wrote.

It remains to be seen whether the new government’s actions can revive the torpid Japanese economy. But for now, the hopes for the country’s immediate economic future remains fairly dim.

“Among the major economies, Japan’s prospects look most disappointing,” Credit Suisse analysts wrote in an end-of-year forecast.